This paper explores the competition between two trading venues, Electronic Communication Networks (ECNs) and Nasdaq market makers. ECNs o¡er the advantages of anonymity and speed of execution, which attract informed traders. Thus, trades are more likely to occur on ECNs when information asymmetry is greater and when trading volume and stock-return volatility are high. ECN trades have greater permanent price impacts and more private information is revealed through ECN trades than though market-maker trades. However, ECN trades have higher ex ante trading costs because market makers can preference or internalize the less informed trades and o¡er them better executions.TECHNOLOGICAL INNOVATIONS THAT ENABLE HIGH-SPEED, low-cost electronic trading systems are dramatically changing the structure of ¢nancial markets. Exchanges and markets around the world are merging or forming alliances to improve liquidity and reduce costs in the face of increased competition from each other and from these computerized trading systems. Trading volume on Electronic Communications Networks (ECNs) has grown rapidly over the past several years. ECNs are now involved in more than a third of Nasdaq trading volume and are attempting to increase their market share in NYSE-listed

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This study utilizes a comprehensive database containing monthly information on the number of market makers for about 5,288 Nasdaq securities over an eight-year period to investigate the impact of competition on spreads. A variety of models are estimated in order to demonstrate the robustness of the results that include four specific findings: (1) the number of market makers has a negative and highly significant impact on spreads; (2) the relation is nonlinear with a decreasing impact by the marginal market maker; (3) Nasdaq spreads have been declining over time; and (4) structural changes in Nasdaq are associated with significant changes in the relationship between spread and the number of market makers. One improvement over the literature includes allowing endogenous competition through the use of instrumental variables.

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